Deutsche Bank Doubts Fred's Headwinds Will Subside In 2H'16; Downgrades To Sell

The discount store operator is likely to be affected by the increasing competition from peers, while its specialty business could be weighed down by a broader slowdown for Hepatitis C drugs, which accounts for 60–70 percent of the company's specialty business.

"We see potential for further downward guidance revisions, in the same vein as in 2H last year, and are modeling modestly below consensus for this year and next year," analyst Paul Trussell wrote in a note.

With second-quarter comp dropping 2 percent, the analyst said Fred's has produced its worst quarterly performance since the fourth quarter of 2012.

Further, the company cut its second-quarter EPS view by $0.195 at the midpoint on the significant gross margin impact and unexpected "direct and indirect remuneration" (DIR) fees assessed during the quarter. As part of the broader industry trend, Trussell sees continued negative impact from reimbursement.

"[W]hile we applaud the new management team's general merchandise margin boosting initiatives implemented over the past several months (such as JDA software, simplifying sourcing, and utilizing e-auctions), we think the low hanging fruit has already been picked, and see fewer offsets ahead while FRED still works to lower cost to fill on the pharmacy side of the business," Trussell noted.

The analyst cut his FY16 EPS estimate to $0.02 (from $0.26), with SSS up 0.3 percent and EBITDA of $52 million. Trussell also slashed his price target to $12 from $15.

Shares of Fred's closed Friday's trading at $14.29 and were down more than 3 percent at time of writing Monday, seen trading at $13.81.

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